Joe Hockey
’s “Son of Wallis" financial system inquiry, which will deliver its interim report by mid-2014, could have enduring ramifications for the banks that make up one-third of Australia’s sharemarket.

The question is, will it flatten the competitive playing field and offer smaller players a return on equity boost, as the bosses of Bendigo & Adelaide Bank and Bank of Queensland hope? Or could it entrench the regulated advantages of the four oligopolists?

Anyone with exposure to Australia’s $450 billion banking sector should understand the threshold policy issues the inquiry will traverse, and start formulating probabilities on the outcomes. A careful analysis suggests it is unlikely to champion radical changes that will disrupt the status quo. This would be good news for investors in the majors, and bad news for everybody else – including their competitors and, more significantly, taxpayers.

In 2012 I was sitting in [then] treasurer
Wayne Swan
’s Sydney office, talking about how to improve the “competitive neutrality" of Australia’s banking system, which the International Monetary Fund says is one of the most concentrated, moral hazard-laden and (for the four “too-big-to-fail" institutions that control it) profitable in the world.

Save for a “successful" $20 billion investment by taxpayers to help maintain a minimum level of liquidity in the residential mortgage-backed securities market – a policy proposal Joshua Gans and I developed – Swan had been surprisingly inert on banking reforms during his time in office. Surprising in the sense that Labor promotes itself as holding the big end of town to account. (Gans was formerly economics professor at Melbourne Business School and is now at the Rotman School of Management, University of Toronto.)

Deposit guarantee

Swan had ignored a (belated) recommendation from his Council of Financial Regulators in 2011 to consider requiring banks to pay for the free taxpayer guarantee of deposits. While the guarantee benefits depositors by reducing default risks, it also assures the stability of the banks’ biggest source of funds and lowers its theoretical cost.

He had been repeatedly outflanked by Joe Hockey, who in 2009 backed this economist’s call for an inquiry to reflect on how the financial architecture that was put in place after the 1997 Wallis review should be modified in light of the many lessons wrought by the GFC.

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In a late 2010 speech, Hockey declared that it was “time to talk banking".

In opposition he was animated by the policy challenge that “the four major banks are too big to fail". He understood that the explicit and implicit taxpayer guarantees that allow the majors to raise money more cheaply and in larger volumes than competitors created “moral hazards" that could wreak havoc down the track by encouraging a “heads bankers win, tails taxpayers lose" dynamic.

Hockey knew that the cornerstone of the big banks’ returns, which are higher than their rivals’, was the fact that regulators allow them to hold less than half the capital, and thus have more than twice the leverage, across their huge home loan books. So the institutions that in principle pose the greatest systemic risks hold the smallest buffers against future losses.

Risks of moral hazard

Hockey opined that “there is clearly a case that Australia’s prudential regulations should continue to evolve to mitigate the new moral hazard risks that have been unearthed as a direct consequence of the taxpayer guarantees".

But his centre-left adversary, treasurer Swan, rejected the inquiry and, more remarkably, dismissed written advice from Treasury after the 2010 election to pursue one.

“Many countries are reviewing their financial regulation frameworks and making substantial changes," Treasury told Swan. “Australia has not undertaken a comparable review since 1997 and we strongly urge you to make this a key priority in your second term."

Sitting in Swan’s office I should not, therefore, have been shocked to hear him speak in awe of the majors’ formidable lobbying powers, which made genuine reforms hard to get off the ground.

His shadow, Joe Hockey, was quick to claim he had no fear tackling Australia’s “taxpayer-guaranteed banks", which he said “are not normal private companies and should not be regulated like normal companies".

A touch of the yips

Yet contemporary evidence implies that the influential banking-bureaucracy nexus has given Australia’s new treasurer the yips.

The Reserve Bank of Australia and Treasury have historically been resistant to initiatives that disrupt the stability of the four oligopolists in the name of enhancing competition.

Both advised
Kevin Rudd
and Swan against assisting the liquidity of the securitised home loan market that smaller lenders relied on. Both also initially opposed the 2009 calls for a Son-of-Wallis inquiry as unnecessary. And both are fond of alleging a trade-off between competition and financial stability. (I’ve never received a response to the retort that a chair with eight legs is stronger than one with four.)

Only a conspiratorial mind would insinuate that the Treasury and RBA’s big-bank bias has anything to do with the fact that Treasury secretaries
Ken Henry
and
Ted Evans
and RBA governor
Ian Macfarlane
have all recently served on major bank boards.

Hockey’s appointment of the assertive former chief executive of CBA,
David Murray
, to run the inquiry was the first win for major bank investors. In 2012 Murray, who spent 39 years at CBA, told 7.30 Report , “I’m known to be a supporter of banks."

Two of the remaining four panel members are also career bankers.
Craig Dunn
, the retiring boss of AMP, was previously head of AMP Bank.
Carolyn Hewson
, an investment banker with Schroders for 14 years, served for a decade as a director of Westpac (and on the board of AMP).

Without executive policy-making experience

Like Murray, neither has executive policy-making or regulatory experience (except as poachers rather than gamekeepers). While the two other panellists, academic
Kevin Davis
and former CSL chief
Brian McNamee
, offer the prospect of independence, Murray will control the show. Further insight into the inquiry’s direction can be gleaned from Murray’s forays into the policy debate.

When the IMF found in a comprehensive 2012 study that the major banks were not holding enough tier-one capital to mitigate the moral hazards flowing from their too-big-to-fail status, Murray was quoted faulting the recommendation, which was ultimately embraced by the Australian Prudential Regulation Authority.

“The issue is not more capital in my mind, it’s more capital intra-cycle," Murray told The Australian Financial Review. “Higher capital at a time when you want to fund the economy and make sure banks can lend – it ultimately constricts the rate of lending growth," he averred. For the avoidance of doubt Murray added that “all the capital in the world is of no value during a liquidity crisis because that’s about a run on a bank".

Another defining policy issue is whether the majors should downgrade their lofty return on equity targets, given the taxpayer protections deployed during the GFC that reduce their commercial risks. It is precisely these government guarantees that give the majors a two-notch credit rating upgrade from Standard & Poor’s, which no other banks receive.

Conflict of aspirations

Hockey was once sympathetic to this view. He noted: “There appears . . . to be a growing conflict between the high-growth aspirations of bank management teams . . . who are focused on maximising shareholder returns, and the longer-term interests of taxpayers and regulators, who are much more eager to ensure that this return maximisation does not come with higher ‘non-core’ risks that trigger bank failures and financial system instability."

He added: “With massive taxpayer risk in play we as policymakers need to decide if we want the major banks to be unrestrained growth stocks, like resources or technology companies. Or do we want the industry to be more akin to bullet-proof utilities that are focused on delivering stable returns to shareholders?"

The chairman of Bendigo & Adelaide Bank,
Robert Johanson
, has made similar remarks, characterising the banks’ pre-GFC profitability as “unusually high and beyond what one would expect of a privileged, government-guaranteed utility".

In contrast, Murray has defended the high-teen returns the majors are able to produce via leveraging their tier-one capital as much as 85 times when advancing home loans.

“When you examine how banks work and how they’re regulated, they need to make a return on equity around 16 or so per cent," Murray informed 7.30 Report. This is in line with pre-GFC averages.

Like a ‘new tax’

Before the 2013 election the Rudd government decided to properly price the taxpayer guarantee of deposits, which was endorsed by the peak regulatory bodies. Murray appeared to criticise the move as akin to introducing a new tax.

“To impose a levy on banks . . . is the same as putting a new tax on the economy," he said. “I am concerned that when we have a good, well-supervised banking system, we would need to have a [bank] levy that has the effect of being another tax."

While Hockey privately says he thinks a levy should be applied, it is being shelved until Murray reviews it. It is hard to imagine he will advocate anything more punitive.

Another encouraging sign for big bank investors is the changes to the inquiry’s terms of reference relative to the original Hockey released in 2010. Back then the inquiry was motivated by the “policy dilemma" unearthed in the GFC that “many financial institutions are now ‘too big to fail’ ".

These and other hard-hitting words, including a reference to the “moral hazard" created when “guaranteeing financial entities", have been replaced with a desire to report on “how Australia funds its growth" and recommendations that “foster an efficient, competitive and flexible financial system".

A puzzle is why the inquiry is being banned from assessing the RBA’s monetary policy process, when this was only recently adjusted to allow the central bank the flexibility to use interest rates to thwart asset price bubbles that induce financial stability risks. This controversial approach has been questioned by some of the more outspoken RBA and Treasury officials, including
David Gruen
and Guy Debelle.

It is another sign that those who have a vested interest in preserving the status quo will win the day.